Investment Decisions: How Framing a Question Can Change Your Answer

(MoneyWatch)  In their behavioral finance book, Nudge, authors Richard Thaler and Cass Sunstein describe the following scenario:

You're suffering from serious heart disease, and your doctor proposes a grueling operation.

• Case A: The doctor says "Of 100 patients who have the operation, 90 are alive after five years."
• Case B: The doctor says, "Of 100 patients who have the operation, 10 are dead after five years."

Even though the two cases are identical, people react very differently to them. In Case A, people tend to focus on the positive way the situation is framed -- the 90 percent odds of success sound comforting. In Case B, people tend to focus on the negative way the situation is framed -- the 10 percent odds of failure sounds alarming. Yet, it can't be that 90 percent odd of success are good at the same time 10 percent odds of failure are bad.

It's not just ordinary people who succumb to framing errors. Even doctors who are told that 90 out of 100 are alive after five years are more likely to recommend the operation than if told 10 out of 100 are dead.

In investing, Monte Carlo simulators are useful during the investment planning process as they can help determine the appropriate asset allocation. However, my experience in working with investors and advisors is they almost always focus on the odds of success and ignore the odds of failure. The optimistic framing of the outcome can cause you to take more risk than might be appropriate. The right approach is to see the problem from both perspectives, paying attention to not only the chance of success, but also the odds of failure. Here's how I might explain a Monte Carlo simulation to an investor:

"It is nice to see that the Monte Carlo simulator shows a 90 percent odds of success. That's the good news. However, I want to make sure you're comfortable that this means we would expect 10 investors out of every 100 to see their portfolio depleted while they're still alive -- a situation I'm sure you would consider more than inconvenient. Are you willing to accept the risk you could be one of those 10? Are there options (e.g., move to an area with a lower cost of living, downsize your home) you can exercise if that situation becomes likely? If not, 10 percent odds of failure might be unacceptable."

You can make better investment decisions by simply having the question framed correctly.

Follow the series:

• Part one: How to Avoid Availability Bias
• Part two: How Framing a Question Can Change Your Answer
• Part three: Investors Can Be Nudged to Do the Right Thing